Wednesday, January 28, 2009

Using Tax Loss Harvesting to Find Dividend Bargains

There are two things that are certain in life- death and taxes. When investors sell a stock for a gain, they must pay either a long term or a short-term capital gains tax. Another example of taxable events concerning dividend investors in particular is that whenever a company sends a dividend check to you, you must recognize it as income and pay taxes on it, even if you choose to directly reinvest it in more shares.

Most investors who choose to avoid paying taxes for as long as possible open a retirement tax deferred account instead of going with the typical taxable account venues. Examples of tax-deferred accounts include Roth IRA’s, regular IRA and 401k.
There are of course pros and cons to investing through a taxable versus a non-taxable investment account.

The main reason for using a tax-deferred account is that your profits – capital gains and dividends are re-invested and compounded tax-free for decades before you even have to pay a dime in taxes.

The main reason why you should utilize taxable accounts is tax loss harvesting. The IRS lets you claim a deduction for investment losses against your ordinary income, up to $3,000 each year. However, if your total net capital loss is more than this amount, you can carry your losses forward to use in future years. If you have taxable events such as dividends or capital gains, you will have to pay taxes to the IRS.

Many investors use tax loss harvesting to sell their biggest losers in the final days of the year in order to get the tax benefits of this action. Investors then have to wait for 30 days before they purchase back the securities that they had sold in order to avoid the wash sale rule.

Given the fact that many investors tend to lock in the losses at year-end for tax purposes, one could expect to find some decent bargains at year-end. In fact, there is a strategy called January Effect which is the tendency of the stock market to increase between December 31 and the end of the first week in January. Once the tax calendar rolls over to a new year on January 1st investors quickly reinvest their money in the market, causing stock prices to rise. Furthermore, once there are fewer sellers left in the markets, an even slight increase in demand could lead to dramatic increases in stocks which were sold at the very end of the prior year.

As a result, I identified the worst performers in the S&P Dividend Aristocrats for 2008. Further research in order to determine how sustainable the financial situation really is, should be performed on a case-by-case basis as well. As a group however all of these companies have a sustainable payout as well as a defensive business model that should work out well in a recessionary period.

The companies for further research include:

Full Disclosure: Long APD,DOV,EMR,MHP,NUE,PEP

Relevant Articles:

- Dividend Aristocrats List for 2009
- When to sell my dividend stocks?
- Why do I like Dividend Aristocrats?
- Worst Performing dividend stocks so far in 2008

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